Rising Inflation in China Could Become the Fly in Bernanke's Soup

Over the weekend, the WSJ reported that inflation is picking up in China, where the November CPI showed gains of 0.6%, the first increase since January 2009. While these gains are currently benign, they have the potential to escalate further in 2010. Firstly the headline Chinese inflation numbers could show strong gains when compared to the weak consumer prices in the first half of 2009. Secondly as the Journal reports both money supply and bank lending in China continue to surge, with money supply growing 30% year over year and new loans rising by $43bn in November. Lastly inflation will trend higher if commodity prices continue their upswing as investors try to hedge a weakening dollar. According to the WSJ:

As headline inflation figures rise, there will be pressure on China's central bank to tighten policy sooner than it might wish. Ben Simpfendorfer, RBS's China economist, says worsening inflation expectations could lead to an interest-rate increase in the second quarter of 2010. A move that soon is something the authorities will want to avoid, especially since it would likely come before similar action in the U.S.

The Fed itself is unlikely to raise rates anytime soon. At least not until the House of Representatives elections in November 2010, not only for political reasons but also because:

1. It wants to continue to roll over the colossal amounts of short term U.S. treasury debt, into longer term paper at low interest rates. As any investment banker would tell you high levels of short term debt are a big no-no for any company because of the huge roll-over risk involved. Several companies including Lehman Brothers have been forced to file for bankruptcy, when their short term debt came due and investors balked at rolling it over into new paper. The United States government is no different. Of the total government debt about 36% is due within 1 year. The Fed is aware of this risk, which is why it has kept short term interest rates near zero. In doing so the Fed is forcing investors to move up the risk curve by buying longer dated government bonds and equities.
2. If the Fed were to raise rates then it would need to make higher interest payments on the $12 trillion of U.S. government debt (soon to be $14 trillion), something the country can ill afford right now due to weak tax revenues (cash inflow) on account of the recession.
3. The Fed is desperately trying to re-inflate the housing bubble by keeping mortgage rates ultra-low so that people can refinance out of higher interest mortgages, thus preventing them from defaulting on their loans. A rise in the Fed funds rate will throw a wrench in this plan.
4. In addition the Fed has been trying to reflate the equity markets by holding down the cost of equity and debt capital, thus encouraging highly leveraged companies like banks and real estate players, to bolster capital by either raising equity or rolling over near term debt maturities into cheap longer term paper.
5. According to Curtis Arledge co- head of U.S. fixed income in New York at BlackRock, persistent unemployment means that the Federal Reserve, won’t raise its benchmark interest rate from near zero through 2010. “I don’t think they’re even going to be thinking about it until the third or fourth quarter of 2010,” says Arledge, who helps oversee more than $500 billion. “It wouldn’t surprise me if it was into 2011.”

So if the Fed cannot raise rates where does this leave China? If China is forced to raise rates before the U.S. to combat increasing inflation and/or developing asset bubbles, it would cause the yuan appreciate as money flows into China to chase higher interest rates. While a rising yuan would no doubt be detrimental to China by making its exports more expensive, it would threaten the United States to a greater degree. A rapidly appreciating yuan would curtail china's current account surplus of U.S. dollars (as exports decline). With less dollars to reinvest in U.S. treasuries, it will complicate Bernanke's job tremendously as the U.S. tries to raise ~$2 trillion in new debt in 2010. Not to mention the existing short term debt that has to be rolled over. So contrary to the widely publicized posturing by U.S. officials imploring China to let the yuan appreciate, a rapidly appreciating yuan would most certainly force Bernanke's hand by making him raise rates sooner to attract capital to fund U.S. deficits. As the WSJ article continues:

Before it's forced to raise rates, China's central bank is likely to attempt to suck money out of the economy in other ways, perhaps via open-market operations to drain liquidity or raising the level of reserves that banks are required to hold. But, holding the line against the inflation headlines will only get harder.

Let us hope China manages, otherwise Bernanke could find himself counting the last few strands left on his shining cranium.